Meet John, a supermarket manager who is married with three school-age children and takes home a comfortably large paycheck. Sure he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake.
Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and can’t borrow the money.
What’s the 43% Rule?
It’s a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t.
In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent, though it might vary a bit from lender to lender. If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all their bills on time.
For other types of loans – debt consolidation loans, for example — a ratio needs to fall between 36 and 49 percent. Above that, qualifying for a conventional loan is unlikely.
The debt-to-income ratio surprises a lot of loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines whether they’ll be able to find a lender.
What is a debt-to-income ratio?
Your debt-to-income ratio compares the amount of your debt (excluding your mortgage or rent payment) to your income. The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).
Put another way, the ratio is a percent of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts.
How To Calculate Your Debt-To-Income Ratio
So the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection.
Calculating your debt-to-income ratio in easy 4 steps:
- Add up what you owe, including credit cards, rent or mortgage payments, car loans, student loans, etc.*
- Then calculate your income: wages, dividends and freelance income, for instance.**
- Now, convert each to a monthly figure. If your annual income is $60,000, the monthly total is $5,000. Do the same for debt. If your annual debt total is $30,000, the monthly total is $2,500.
- Now divide your debt by your income and multiply by 100 to arrive at a percentage representing your debt-to-income ratio. In this example, that would be 30,000 divided by 60,000 = .5 x 100 = 50%.
*Payments That Are Included In Monthly Debt Payments When Calculating DTI
- Monthly credit card payments (you can use the minimum payment when calculating your DTI ratio)
- Monthly mortgage payment
- Monthly car payment
- Monthly student loan payments
- Monthly personal loan payments
- Monthly debt consolidation loan payments
**Income Included In Your Monthly Income When Calculating DTI
- Income from wages, salary
- Income from tips, if applicable
- Income from self-employment (make sure it is verifiable via tax return)
- Income from alimony
- Income from child support
- Income from social security
- Income from a pension
- Disability income
- Income from investments such as rental properties, stock dividends (must be documented on tax returns)
How To Improve Your Debt-To-Income Ratio
The goal is 43% or less, and lenders often recommend taking remedial steps if your ratio exceeds 36%. There are two options to improving your debt-to-income ratio:
- lower your debt
- increase your income
Neither one is easy for many people, but there are strategies to consider that might work for you.
Lower Your Debt Payments
For most people, attacking debt is the easier of the two solutions. Start off by making a list of everything you owe. The list should include credit-card debts, car loans, mortgage- and home-equity loans, homeowners’ association fees, property taxes and expenses like internet, cable and gym memberships. Add it all up.
Then look at your monthly payments. Are any of them larger than they need to be? How much interest are you paying on the credit cards, for instance. While you may be turned down for a debt consolidation loan due to a high debt-to-income ratio, you can still pursue a debt consolidation alternative: nonprofit debt management. With nonprofit debt management, you can consolidate your debt payments with a high debt-to-income ratio because you are not taking out a new loan. You still qualify for lower interest rates which can lower your monthly debt payments, thus lowering your ratio.
Remember that improving your DTI ratio is based on debt payments, and not debt balances. You can lower your debt payments by finding a debt solution with lower interest rates or a longer payment schedule. Another way to lower your monthly debt payment is to consider a nonprofit debt consolidation program that lowers your interest rates and your payments. Lowering your monthly debt payments can help you improve your ratio and qualify for a loan.
Other alternatives to consider to lower your expenses and pay off debt:
- Cancel your cable subscription or opt for a cheaper plan to reduce your monthly costs. Then look at your other telecommunications expenses. Can you move to a cell-phone plan that uses less data and costs less?
- Put off large purchases until you have more cash. The more cash you can apply to a purchase, the less you have to borrow, so open a savings account to help pay for big ticket items such as cars and vacations.
- If you have student loans, the bane of the Millennial generation, see if you can get a lower required payment. Lenders use your required minimum debt payment to arrive at an income-to-debt ratio, so the lower the required payment, the better your ratio. Generally, nothing prevents you from making larger payments if you have extra cash — that’s not the issue here.
- Refinance loans if it makes sense. Interest rates have fallen dramatically since the Great Recession and remain low. Check with a lender to see if refinancing, which might involve upfront costs, makes financial sense.
- Change your shopping habits. Consider shopping for groceries at big-box retail stores like Wal-Mart. See if you can repair, rather than replace, tired appliances. Try to keep your old car running for another year or two and avoid the impulse to buy the fashion-forward clothes when the slightly dated ones will do.
- Sell unneeded stuff on eBay or Craig’s List and apply the proceeds to your debt-payment plan.
- Don’t buy on impulse. If anything is sure to undermine your strategy, it’s unnecessary feel-good purchases.
Most important, make a realistic budget designed to lower your debt and stick with it. Once a month, recalculate your loan-to-income ratio and see how fast it falls under 43%.
Increase Your Income
Improving the income side always is more difficult because it requires the one thing no one has enough of – time. Finding a night-time or weekend job that produces even a couple of hundred dollars could be the difference maker in getting your debt-to-income ratio below 43%.
Finding a combination of the two – part-time job, plus reducing expenses – is the ultimate solution and might even bring your debt-to-income ratio down below the 36% level that lenders are anxious to do business with.
Why is monitoring your debt-to-income ratio important?
Keeping track of your debt-to-income ratio can help you avoid “creeping indebtedness,” or the gradual rising of debt. Impulse buying and routine use of credit cards for small, daily purchases can easily result in unmanageable debt. By monitoring your debt-to-income ratio, you can:
- Make sound decisions about buying on credit and taking out loans.
- See the clear benefits of making more than your minimum credit card payments.
- Avoid major credit problems.
Creditors look at your debt-to-income ratio to determine whether you’re creditworthy. Letting your ratio rise above 20 percent may:
- Jeopardize your ability to make major purchases, such as a car or a home.
- Keep you from getting the lowest available interest rates and best credit terms.
- Cause difficulty getting additional credit in case of emergencies.
Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. Know your ratio and keep it low.
Is my debt-to-income ratio too high?
The lower your debt-to-income ratio, the better your financial condition. You’re probably doing OK if your debt-to-income ratio is lower than 19%. Though each situation is different, a ratio of 20% or higher is a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take home pay on interest, freeing up money for other budget priorities, including savings.
Irby, L. (2016, June 8). How to Lower Your Debt-to-Income Ratio. Retrieved from: http://credit.about.com/od/reducingdebt/qt/lowerdebtratio.htm
Schreiner, E. (ND) How to Lower Your Debt Ratio. Retrieved from: http://budgeting.thenest.com/lower-debt-ratio-3921.html
Emisar, O. (2011, September 8) 10 Tips for Improving Your Debt to Income Ratio. Bright Hub. Retrieved from: http://www.brighthub.com/money/personal-finance/articles/121853.aspx
NA, ND. Understanding Your Debt-to-Income Ratio. Retrieved from: https://www.bankofamerica.com/credit-cards/education/what-is-debt-to-income-ratio.go